6.4 Variable Annuities

Variable Annuities

A variable annuity (VA) is the only annuity in which the owner bears the investment risk. Premiums (net of charges) are invested in the insurer's separate account - a portfolio of subaccounts resembling mutual funds (stock, bond, balanced, money market). The account value, and ultimately the income, rises and falls with subaccount performance. There is no guaranteed minimum return on the base contract.

Because the separate account exposes the owner to securities risk, a VA is regulated as a security under federal law in addition to being an insurance product (a "dual" product).

Licensing and Regulation

Selling variable annuities requires BOTH:

• A state life insurance license, AND
• A securities registration (FINRA Series 6 or 7, with Series 63 as required) - the agent must be a registered representative.

A VA is registered with the SEC and FINRA, and the prospect must receive a prospectus before or at the time of solicitation. This is the most-tested distinction on the exam:

Accumulation Units vs. Annuity Units

During the accumulation phase, premiums purchase accumulation units; both the number of units (as you contribute) and their value (as markets move) fluctuate. At annuitization, the value is converted into a fixed number of annuity units. From then on, the number of annuity units is fixed, but each unit's value varies monthly with separate-account performance - which is why variable income payments change.

Many VAs use an assumed interest rate (AIR) to set the first payment. If actual separate-account performance exceeds the AIR, the next payment rises; if it falls below the AIR, the payment declines; if it equals the AIR, the payment is unchanged.

Fees and Riders

Variable annuities carry the highest fees of any annuity, often 2-3%+ annually:

• Mortality & Expense (M&E) charge - 0.5-1.5%; funds the death-benefit guarantee and insurer risk.
• Administrative charge - 0.1-0.3%.
• Subaccount management fees - 0.5-1.5%.
• Optional rider fees - 0.5-1.5% (e.g., GMIB/GMWB living benefits, enhanced death benefit).

A common guaranteed death benefit rider pays beneficiaries at least the total premiums paid even if the account has fallen - e.g., $100,000 invested, account drops to $80,000 at death, beneficiary still receives $100,000. Because of high fees and securities risk, suitability and full prospectus disclosure are heavily regulated; surrender charges still apply during the early years.

Subaccounts, the separate account, and prospectus delivery

The defining feature of a variable annuity is that net premiums flow into the insurer's separate account, divided into subaccounts that resemble mutual funds spanning equities, bonds, balanced strategies, and money markets. The separate account is insulated from the insurer's general creditors and is not part of the insurer's guaranteed obligations, which is precisely why the owner — not the insurer — bears investment risk and why the contract is a federally regulated security.

Before or at the time of solicitation the prospect must receive a prospectus filed with the SEC; failing to deliver it, or making projections of guaranteed returns, is a serious sales-practice violation that the exam treats as automatic grounds for discipline.

AIR mechanics and living-benefit riders

The assumed interest rate (AIR) is the performance benchmark that sets a variable annuity's payments after annuitization. The mechanic is mechanical: if actual separate-account performance exceeds the AIR, the next payment rises; if it falls short, the next payment drops; if it equals the AIR, the payment is unchanged.

Living-benefit riders address the owner's market risk for an added fee: a Guaranteed Minimum Income Benefit (GMIB) guarantees a floor annuitization value, while a Guaranteed Minimum Withdrawal Benefit (GMWB) guarantees a stream of withdrawals regardless of account performance. These riders, the M&E charge, and subaccount fees together make the VA the highest-cost annuity, so a recommendation must survive a documented suitability and best-interest review.

Fees, death benefits, and the suitability bar

Variable annuities carry the highest costs of any annuity, frequently totaling 2–3%+ per year: a mortality & expense (M&E) charge funding the death-benefit guarantee, an administrative charge, subaccount management fees, and optional rider charges. A standard guaranteed death benefit ensures beneficiaries receive at least total premiums paid even if the account has fallen — for example, $100,000 invested that drops to $80,000 still pays the beneficiary $100,000. Surrender charges still apply in the early contract years.

Because the owner bears market risk, the product is a security, and the fees are steep, a VA recommendation must clear documented suitability and best-interest review: the producer weighs the client's time horizon, risk tolerance, liquidity needs, and tax situation, and confirms that cheaper or guaranteed alternatives were considered before placing the contract.

When a variable annuity is appropriate

A variable annuity fits an investor with a long time horizon, higher risk tolerance, and a desire for tax-deferred growth who has already maxed out qualified plans like a 401(k) or IRA. It is generally inappropriate to place a VA inside an IRA solely for tax deferral, since the IRA is already tax-deferred and the VA's fees add cost without adding a tax benefit — a frequently tested unsuitable-sale scenario. Short time horizons, low risk tolerance, or an immediate need for liquidity all argue against the product.

The producer documents that the client understands market risk, the fee load, and the surrender schedule before recommending the contract.